New guidance and new challenges for LA’s mansion tax

A new transfer tax of up to 5.5 percent will soon be imposed on sales of high-value real estate in the City of Los Angeles. This new tax was approved by voters under Measure ULA and is commonly referred to as the “Mansion Tax” and critically dubbed “the worst April Fools’ joke ever” with its effective date being April 1, 2023. As the effective date draws near, the real estate market in the City of Los Angeles has been busy with parties working hard to get their deals closed by March 31, 2023 to avoid the significant cost increase that will be incurred for transactions that close from and after April 1. The City of Los Angeles has also been busy with the release of its much-anticipated FAQs on March 16, 2023, and the filing on March 15, 2023 of a memorandum supporting a motion to dismiss a federal lawsuit challenging the Mansion Tax.

Overview and impact

The current documentary transfer tax rate in the City of Los Angeles is $5.60/$1,000 of value ($1.10 county + $4.50 city) or 0.56 percent. This tax is calculated on the net value, meaning any existing liens or encumbrances remaining on the property at the time of the transfer are excluded from the value on which the tax applies.

The Mansion Tax imposes an additional tax equal to (i) 4 percent of the consideration or value for properties with consideration or value ranging between $5,000,000 and $9,999,999.99 and (ii) 5.5 percent of the consideration or value for properties with consideration or value equal to or greater than $10,000,000.

Unlike the current documentary transfer tax, this new tax is calculated on the gross value, meaning it is inclusive of any liens or encumbrances remaining on the property at the time of the transfer. The threshold values will be adjusted annually based on the Consumer Price Index.
To illustrate the impact of the Mansion Tax:

 

The Mansion Tax will not just impact buyers and sellers of real estate. For example, this new transaction cost will likely cause buyers of rental properties to attempt to increase rents.

The Mansion Tax will apply regardless of whether the real property is sold at a gain or loss, and the tax will apply to all types of real property sold in the City of Los Angeles (eg, single family, multifamily, retail, office, industrial, land) valued over $5,000,000 unless the transaction is otherwise exempt. There are stated exemptions that apply to the Mansion Tax that do not apply to the current documentary transfer tax, such as transfers to certain nonprofit, affordable housing, and tax-exempt organizations. Any parties seeking to fall under one of these stated exemptions should work with their legal counsel to determine that the transferee in fact qualifies for such exemption.

Recent developments

On March 16, 2023, the City of Los Angeles released its first set of guidance – a list of FAQs providing high-level answers to general questions about the Mansion Tax. While the FAQs leave many questions unanswered, there now is a calculator for parties to use when determining the City of Los Angeles transfer tax due, including the current documentary transfer tax and the new Mansion Tax, if appliable. However, the calculator does not include the county tax of $1.10/$1,000, so that amount must be added to the total city tax in order to have a full picture of the transfer tax costs.

The Director of Finance anticipates that there will be substantial recording volume leading up to March 31, 2023, with potential for recordings to spill over into April. The FAQs specifically state, “Transfer Tax is due at the time the document is recorded unless there is a valid exemption claimed. All Title-ensured transactions are recorded the same day received. If a deed is received in the mail, the County looks at the date the document was received in their building.”

Based on this, parties should consider the following steps: (i) send any transfer instruments being mailed to the County for recording via Certified Mail with proof of delivery or via another mail courier with evidence of delivery; (ii) for any transfer instruments being hand-delivered to the County for recording, obtain a date-stamped signature acknowledging receipt; and (iii) for any transfer instruments being recorded electronically through title companies or other services, ensure they are date-stamped as to electronic submission and obtain confirmation of receipt by the County Recorder.

Uncertainty remains in the marketplace

Despite the release of the FAQs, uncertainty remains in the marketplace. Specifically, it is not yet clear whether the same city and state exemptions will apply to the Mansion Tax as they do for the current documentary transfer tax (eg, gifts, foreclosures, proportionate interest transfers). It is also not yet clear whether entity interest transfers resulting in a direct or indirect change in control of an entity holding real property in the City of Los Angeles will be subject to the Mansion Tax as is the case for the current documentary transfer tax. We anticipate that the same city and state exemptions will apply to the Mansion Tax and that the Mansion Tax will also be imposed on change in control transactions. Finally, while also unclear, we anticipate that the Mansion Tax will apply on a property-by-property basis for portfolio transactions.

To provide clarity on these and other uncertainties, Measure ULA authorizes the City of Los Angeles Director of Finance to issue rules and regulations on the implementation and enforcement of the Mansion Tax, including defining the term “realty sold” as to the Mansion Tax and the current city documentary transfer tax. We have been told by the City of Los Angeles that guidance is forthcoming. As of the date of this Alert, no guidance has been released by the City other than the FAQs.

Parties to real estate transactions that do not close by the effective date of the Mansion Tax should take this new cost into account with respect to those transactions. For transactions that must close on or after April 1, 2023, we recommend discussing potential planning opportunities with your legal and tax advisors before engaging in such transactions, and, if the Mansion Tax is due, consider making a payment preserving the right to obtain a refund if possible.

Legal challenges

While the effective date is drawing near, the validity of the Mansion Tax has been put into question. On December 21, 2022, the Howard Jarvis Taxpayers Association and the Apartment Association of Greater Los Angeles filed a lawsuit in superior court, claiming that the California Constitution prohibits cities or counties from designating real estate transfer taxes for special purposes. In addition, on January 6, 2023, Newcastle Courtyards LLC and the Mani Benabou Family Trust filed lawsuits in federal court and in superior court alleging that the Mansion Tax is an unlawful special tax, and claiming that it violates property owners’ equal protection rights under the 14th Amendment of the US Constitution and the equal protection clause of the California Constitution. The City filed a memorandum supporting its motion to dismiss on March 15, 2023. In its memorandum, the City argues that the lawsuit is barred because the Tax Injunction Act (28 U.S.C. § 1341) prohibits challenges to state and local taxes in federal court unless an adequate forum to litigate the challenge does not exist, that the plaintiff may not invoke a federal court’s jurisdiction when the superior court already has jurisdiction, and that the plaintiff failed to comply with the statutory requirements for commencing litigation to invalidate the law. As highlighted in the motion to dismiss, there are already two state court cases pending before the Los Angeles County Superior Court.

If the motion to dismiss the federal lawsuit is denied, the significance of the City’s Tax Injunction Act argument will be amplified and would likely impact other tax types and jurisdictions because Tax Injunction Act arguments are frequently invoked when taxpayers bring any state tax case in federal court. The outcome of these lawsuits – both federal and state – remains to be seen, but as of the date of this Alert, the Mansion Tax is scheduled to go into effect on April 1, 2023.

Separately, a ballot initiative known as The Taxpayer Protection and Government Accountability Act, which could end the Mansion Tax and other similar measures, has gathered enough signatures and is expected to appear on the California ballot in 2024. Among other items, this act would require approval by two-thirds of voters for all new local special tax increases and would invalidate any local special tax increases adopted after January 1, 2022 that were not adopted with two-thirds voter approval (including the Mansion Tax, which was passed by a margin of approximately 58 percent to 42 percent). As currently drafted, this measure does not provide for tax refunds or rebates for amounts paid under any tax that would be invalidated if it were to pass.

For more information, please contact Stephanie Pfaff or Anosh Ali.

The authors thank David Pope for his contributions to this alert.